Founded in 1993 by brothers Tom and David Gardner, The Motley Fool helps millions of people attain financial freedom through our website, podcasts, books, newspaper column, radio show, and premium investing services.

Grounds for Buying Starbucks?

The coffeehouse's valuation is looking more attractive after a first-quarter decline.

It's always nice to have an old friend move back into the neighborhood. Starbucks(NASDAQ:SBUX) has been making me feel lonely ever since it topped out at $64.26 at the end of last year. Not that I tired of its coffee, mind you, and especially not that early-morning kick from a Caramel Macchiato. I just wasn't comfortable buying the stock when it was trading at 67 times the previous year's earnings of $0.95 a share.

After getting beaten down over the first quarter to around $47 per share today, my friend looks to be back. Not necessarily right next door. Not quite yet. But definitely in the neighborhood.

The company recently reported first-quarter revenues of $599 million with overall sales up 22%. Comparable-store sales for the five-week period ended April 3 were up 6%. The Street has been disappointed with the March comps number after 7% and 9% comps in January and February. The tone of the commentaries has been one of concern over slowing sales growth. All this despite the fact that back in October, the company laid out revenue targets for 2005 that included overall sales growth of approximately 20% and comps in the 3% to 7% range. Is anyone listening?

Now, I'm fully aware of the investment conundrum presented by a stock like Starbucks. When does explosive growth turn into solid growth and eventually into a moderately growing cash cow?

Well, the track record for Starbucks is pretty compelling, especially for a concept that's no longer new to the market: The company has seen compound annual EPS growth of 41% over the past four years and last-year EPS up 44% on revenue growth of 25%. Looking forward, consensus analyst estimates call for EPS growth of 24% this year and 21% next year.

Let's do a valuation exercise to find a good neighborhood for this stock. I prefer the old-fashioned method of discounting cash flows. For a company like Starbucks, I'll assume that EPS is an appropriate proxy for cash flows over the long haul -- and although this will be inaccurate to the extent that capital expenditures exceed depreciation and that there is a net addition to noncash, nondebt working capital, it's a decent start.

The company estimates 2005 earnings to grow between 20% and 25%. Take the low end of 20% and carry that out for five years. (Remember that Starbucks has a 41% compound EPS growth rate for the past four years.) Then cut the growth back to 10% for years six through 10, and use a 5% growth rate into perpetuity starting with year 11. Discounting those cash flows back to today at a 9% cost of money yields a valuation of $56.51.

In the spirit of Benjamin Graham, a founding father of value investing, let's say we're willing to pay only 80% of our math-based valuation, just to be on the safe side. (Graham would have been more conservative, but hey, the market runs a tighter ship these days.) Embedding that margin of safety yields a valuation for Starbucks of around $45. That means $47 is not "screaming buy" territory, but it's certainly back to a more comfortable neighborhood, particularly for an investor who values fundamentals, growth, and the value of a brand.

Give me just a little more gloom and doom in the news, enough to get the stock below $45, and it might be time to throw a homecoming party.

Fool contributor Timothy M. Otte was kicked out of his local Starbucks last week after an obvious overdose of caffeine and cinnamon pastry, but he doesn't own the stock of any company mentioned in this article.